Bill Nygren had a tough year, as his largest holding Washington Mutual become insolvent. He sold his position before that, but still had large loss. The third quarter was a good quarter for him, as his fund lost only 1%. He bought American Express (AXP – $35) and Boeing (BA – $57).
Bill Nygren Letter to Shareholders
I’m writing this letter on the last day of the quarter. The stock market fell more points yesterday than it ever has before, the S&P 500 is down 19% for the year, and the House has voted down the Treasury’s plan to stabilize the credit markets. During the quarter we witnessed the demise of Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual and Wachovia Bank. Just one year ago those companies had a combined market value of over $400 billion. In such unsettled times I thought it might be useful to answer some basic questions that our shareholders have been frequently asking.
Should I sell stocks now?
It’s unfortunate that this question is always asked after large declines rather than before. Everyone’s risk tolerance is different, but if you can’t sleep at night because you are so worried about stocks falling more, then yes, you should sell enough so you can sleep. It’s never worth risking your health. You should also sell if you have invested money in the stock market that you know you will need to spend soon. We always encourage limiting stock market investments to capital that you aren’t likely to need within the next five years.
If you are sleeping well and won’t be a forced seller anytime soon, then we strongly believe you should not sell. In fact, we believe the decline in the market has created a very attractive environment for investing new capital. For most people, the right question to ask after a big decline is: “Should I be investing more?” We believe this is a very good time to be a cautiously optimistic buyer. I say “cautiously” because volatility has been so extreme that it seems prudent to keep some capital in reserve so that if prices fall further you can take advantage of them. Finally, remember that our Funds, like most equity mutual funds, are usually close to fully invested, so if you want to own more stocks, you need to invest additional capital.
Why do you say stocks are attractive?
Our view on whether a stock is attractive or not is based on the difference between our estimate of long-term value and the current stock price. When the stock price is well below our business value estimate, we say that stock is attractive. We started 2008 believing that many stocks were attractive — priced well below business value and likely to produce long-term returns that would significantly exceed returns on fixed income investments. Most of the businesses we own, with the exception of financial services companies, have grown business value this year more slowly than we expected, but they did grow. With stock prices down and business value up slightly, the discount to estimated fair value has increased. We therefore believe that stocks have become even more attractive investments.
You thought stocks were cheap last year, what went wrong?
Bear markets typically follow periods of excessive valuation, meaning stocks were selling at very high multiples of earnings. When price-to-earnings ratios become elevated, other investment opportunities, such as fixed income, become attractive substitutes. Investors sell stocks, driving down prices and increasing their prospective returns, and they buy bonds, reducing their yields. Eventually stocks look more attractive than bonds and the whole cycle repeats. This time, however, stock P/E ratios were not historically high, and competing bond yields did not look compelling in comparison. This market has been less about correcting overly generous valuations, and more about the fear that the losses in the banking system will spread to the rest of the economy. It wasn’t the typical valuation correction, and we didn’t anticipate the financial services collapse.
Why do you own any financial services companies?
Financial services companies are the exception to my comment that most of our stocks have slightly higher business value estimates today than they did a year ago. Mortgage losses for financials far exceeded our expectations and resulted in significant decreases to our value estimates. However, for most of these companies, stock prices have declined far more than estimated value. Therefore, their discount to value has grown. And for the survivors, the current turmoil has provided opportunities to make acquisitions that appear to have been real bargains. JPMorgan purchased Bear Stearns and Washington Mutual for almost nothing. Citigroup has announced the same with Wachovia. These companies sell at low price-to-earnings and price-to-book ratios, have value additive acquisition opportunities, and face less competition than they previously did. We believe the winners will emerge as very strong companies.
What did you miss on Washington Mutual?
Washington Mutual was held in all three Funds I co-manage. We sold our position during the quarter when it appeared that regulators were increasingly looking at mark-to-market implied losses, which eliminated the chance that Washington Mutual could, over time, earn back its mortgage losses. Selling was the right decision but by the time we sold, the damage had been done. Owning Washington Mutual was a big mistake for which I fully accept responsibility. Though we believed home prices had been rising at an unsustainable pace, we took comfort that previous home price bubbles had corrected with home prices plateauing for several years rather than sharply falling. Expecting that to continue, I took too much comfort in the fact that the overwhelming majority of mortgages Washington Mutual owned had balances of less than 80% of appraised value. Believing that the collateral was so valuable, I wasn’t as concerned as I should have been with softening underwriting standards. After all, if the borrower defaulted, the house could still be sold for more than the mortgage debt. After nationwide prices fell 20%—and further in hot markets—the collateral was no longer worth more than the loan, and serious losses resulted. A mortgage market previously viewed as secure became viewed as very risky. Sellers flooded the market, and prices fell sharply. Because of its leverage, Washington Mutual’s assets, marked-to-market, were no longer greater than its liabilities. Ironically, the asset we’ve always believed was under appreciated, its strong retail deposit base, is now owned by another of our holdings, JP Morgan. Though there are many lessons to be learned from this error, perhaps the most important is that in today’s economic climate, we need to consider a broader array of outcomes than we previously considered, especially for companies that employ financial leverage.
Do you think the Paulson plan can work?
Yes. Every banking executive we talk to says their models show that mortgages are worth much more than they are selling for in the market. It makes sense to us that mortgages have become undervalued because so many financial firms have been forced to sell their positions. Market prices of mortgages fell which created losses and reduced the equity of the firms that held them. With typical leverage ratios of 15:1, each $1 loss forced the sale of $14 of assets, primarily mortgages. That further depressed prices, increasing losses, decreasing equity, and forcing more sales. The downward spiral fed on itself. In most markets, value buyers step in to take advantage of low prices and reverse that vicious cycle. But because the mortgage market is so large, that process will take a long time unless a very large investor intervenes. The government, borrowing for thirty years at less than a 5% interest rate, has more attractive access to capital than any private investor. That makes it especially well-suited to step in and eliminate the supply-demand imbalance. As Warren Buffett said, “People who are buying these instruments in the market are expecting to make 15 to 20 percent…If they (the government) do it right…I think they’ll make a lot of money.” I agree. Many say the proposal forces Main Street to bail out Wall Street. I see it as Main Street taking advantage of Wall Street’s mistakes. Investing $700 billion in cheap mortgages should yield annual profits of double-digit billions, and have the nice side-effect of reversing the downward spiral in prices. If the process is not politicized, and the money is simply invested in attractively priced debt securities, we could be arguing several years from now about whether the profits should be spent on increased services or returned through lower taxes.
The market decline has been unpleasant and the landscape is changing rapidly, so it is hard to anticipate what will happen tomorrow or next week. But as long-term investors we think about five years from now, and it is easy to be excited about the opportunities we see today.
American Express (AXP – $35)
American Express is a leading credit card issuer and network operator. Viewed by many as the premier brand in credit cards, American Express consistently attracts higher spending, more profitable customers. For that reason, it usually sells at a much higher P/E multiple than other financial services companies. That usually prevents us from believing that American Express is undervalued. In fact, just last year when most financials were priced at about 10 times earnings, American Express stock reached an all-time high of $66 with earnings of $3.29, for a multiple of 20 times. Profits at American Express are down this year, but have held up well relative to other financial services companies. We believe that profits at American Express will fully recover and when that happens, we believe that the stock will again sell at a premium P/E multiple.
Boeing (BA – $57)
The Boeing Company is a leading defense contractor and commercial jet manufacturer. Last year Boeing stock reached $108 because investors were excited about prospects for commercial aviation. As oil prices rose, concerns mounted about the health of the airline industry, especially airlines based in the United States . Though we share those concerns, we note the strength of non-U.S. airlines and also the compelling economics, driven by better fuel efficiency, for modernizing the fleet. More importantly, we focus on the value of Boeing’s defense division, which attracts far less attention than commercial aviation does. We believe that if one values its defense business as other publically traded defense contractors are valued, it is nearly worth Boeing’s current stock price, which means the price for commercial aviation is trivial. We believe Boeing is an exceptional value selling at only 8 times expected 2009 earnings.
Bill Nygren Letter to Shareholders
I’m writing this letter on the last day of the quarter. The stock market fell more points yesterday than it ever has before, the S&P 500 is down 19% for the year, and the House has voted down the Treasury’s plan to stabilize the credit markets. During the quarter we witnessed the demise of Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual and Wachovia Bank. Just one year ago those companies had a combined market value of over $400 billion. In such unsettled times I thought it might be useful to answer some basic questions that our shareholders have been frequently asking.
Should I sell stocks now?
It’s unfortunate that this question is always asked after large declines rather than before. Everyone’s risk tolerance is different, but if you can’t sleep at night because you are so worried about stocks falling more, then yes, you should sell enough so you can sleep. It’s never worth risking your health. You should also sell if you have invested money in the stock market that you know you will need to spend soon. We always encourage limiting stock market investments to capital that you aren’t likely to need within the next five years.
If you are sleeping well and won’t be a forced seller anytime soon, then we strongly believe you should not sell. In fact, we believe the decline in the market has created a very attractive environment for investing new capital. For most people, the right question to ask after a big decline is: “Should I be investing more?” We believe this is a very good time to be a cautiously optimistic buyer. I say “cautiously” because volatility has been so extreme that it seems prudent to keep some capital in reserve so that if prices fall further you can take advantage of them. Finally, remember that our Funds, like most equity mutual funds, are usually close to fully invested, so if you want to own more stocks, you need to invest additional capital.
Why do you say stocks are attractive?
Our view on whether a stock is attractive or not is based on the difference between our estimate of long-term value and the current stock price. When the stock price is well below our business value estimate, we say that stock is attractive. We started 2008 believing that many stocks were attractive — priced well below business value and likely to produce long-term returns that would significantly exceed returns on fixed income investments. Most of the businesses we own, with the exception of financial services companies, have grown business value this year more slowly than we expected, but they did grow. With stock prices down and business value up slightly, the discount to estimated fair value has increased. We therefore believe that stocks have become even more attractive investments.
You thought stocks were cheap last year, what went wrong?
Bear markets typically follow periods of excessive valuation, meaning stocks were selling at very high multiples of earnings. When price-to-earnings ratios become elevated, other investment opportunities, such as fixed income, become attractive substitutes. Investors sell stocks, driving down prices and increasing their prospective returns, and they buy bonds, reducing their yields. Eventually stocks look more attractive than bonds and the whole cycle repeats. This time, however, stock P/E ratios were not historically high, and competing bond yields did not look compelling in comparison. This market has been less about correcting overly generous valuations, and more about the fear that the losses in the banking system will spread to the rest of the economy. It wasn’t the typical valuation correction, and we didn’t anticipate the financial services collapse.
Why do you own any financial services companies?
Financial services companies are the exception to my comment that most of our stocks have slightly higher business value estimates today than they did a year ago. Mortgage losses for financials far exceeded our expectations and resulted in significant decreases to our value estimates. However, for most of these companies, stock prices have declined far more than estimated value. Therefore, their discount to value has grown. And for the survivors, the current turmoil has provided opportunities to make acquisitions that appear to have been real bargains. JPMorgan purchased Bear Stearns and Washington Mutual for almost nothing. Citigroup has announced the same with Wachovia. These companies sell at low price-to-earnings and price-to-book ratios, have value additive acquisition opportunities, and face less competition than they previously did. We believe the winners will emerge as very strong companies.
What did you miss on Washington Mutual?
Washington Mutual was held in all three Funds I co-manage. We sold our position during the quarter when it appeared that regulators were increasingly looking at mark-to-market implied losses, which eliminated the chance that Washington Mutual could, over time, earn back its mortgage losses. Selling was the right decision but by the time we sold, the damage had been done. Owning Washington Mutual was a big mistake for which I fully accept responsibility. Though we believed home prices had been rising at an unsustainable pace, we took comfort that previous home price bubbles had corrected with home prices plateauing for several years rather than sharply falling. Expecting that to continue, I took too much comfort in the fact that the overwhelming majority of mortgages Washington Mutual owned had balances of less than 80% of appraised value. Believing that the collateral was so valuable, I wasn’t as concerned as I should have been with softening underwriting standards. After all, if the borrower defaulted, the house could still be sold for more than the mortgage debt. After nationwide prices fell 20%—and further in hot markets—the collateral was no longer worth more than the loan, and serious losses resulted. A mortgage market previously viewed as secure became viewed as very risky. Sellers flooded the market, and prices fell sharply. Because of its leverage, Washington Mutual’s assets, marked-to-market, were no longer greater than its liabilities. Ironically, the asset we’ve always believed was under appreciated, its strong retail deposit base, is now owned by another of our holdings, JP Morgan. Though there are many lessons to be learned from this error, perhaps the most important is that in today’s economic climate, we need to consider a broader array of outcomes than we previously considered, especially for companies that employ financial leverage.
Do you think the Paulson plan can work?
Yes. Every banking executive we talk to says their models show that mortgages are worth much more than they are selling for in the market. It makes sense to us that mortgages have become undervalued because so many financial firms have been forced to sell their positions. Market prices of mortgages fell which created losses and reduced the equity of the firms that held them. With typical leverage ratios of 15:1, each $1 loss forced the sale of $14 of assets, primarily mortgages. That further depressed prices, increasing losses, decreasing equity, and forcing more sales. The downward spiral fed on itself. In most markets, value buyers step in to take advantage of low prices and reverse that vicious cycle. But because the mortgage market is so large, that process will take a long time unless a very large investor intervenes. The government, borrowing for thirty years at less than a 5% interest rate, has more attractive access to capital than any private investor. That makes it especially well-suited to step in and eliminate the supply-demand imbalance. As Warren Buffett said, “People who are buying these instruments in the market are expecting to make 15 to 20 percent…If they (the government) do it right…I think they’ll make a lot of money.” I agree. Many say the proposal forces Main Street to bail out Wall Street. I see it as Main Street taking advantage of Wall Street’s mistakes. Investing $700 billion in cheap mortgages should yield annual profits of double-digit billions, and have the nice side-effect of reversing the downward spiral in prices. If the process is not politicized, and the money is simply invested in attractively priced debt securities, we could be arguing several years from now about whether the profits should be spent on increased services or returned through lower taxes.
The market decline has been unpleasant and the landscape is changing rapidly, so it is hard to anticipate what will happen tomorrow or next week. But as long-term investors we think about five years from now, and it is easy to be excited about the opportunities we see today.
American Express (AXP – $35)
American Express is a leading credit card issuer and network operator. Viewed by many as the premier brand in credit cards, American Express consistently attracts higher spending, more profitable customers. For that reason, it usually sells at a much higher P/E multiple than other financial services companies. That usually prevents us from believing that American Express is undervalued. In fact, just last year when most financials were priced at about 10 times earnings, American Express stock reached an all-time high of $66 with earnings of $3.29, for a multiple of 20 times. Profits at American Express are down this year, but have held up well relative to other financial services companies. We believe that profits at American Express will fully recover and when that happens, we believe that the stock will again sell at a premium P/E multiple.
Boeing (BA – $57)
The Boeing Company is a leading defense contractor and commercial jet manufacturer. Last year Boeing stock reached $108 because investors were excited about prospects for commercial aviation. As oil prices rose, concerns mounted about the health of the airline industry, especially airlines based in the United States . Though we share those concerns, we note the strength of non-U.S. airlines and also the compelling economics, driven by better fuel efficiency, for modernizing the fleet. More importantly, we focus on the value of Boeing’s defense division, which attracts far less attention than commercial aviation does. We believe that if one values its defense business as other publically traded defense contractors are valued, it is nearly worth Boeing’s current stock price, which means the price for commercial aviation is trivial. We believe Boeing is an exceptional value selling at only 8 times expected 2009 earnings.
